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Charging Order Protection

One of the pillars of asset protection planning is privacy. As we’ve discussed previously, many lawsuits are just a form of legal extortion. Plaintiff attorneys know that most people don’t want to spend tens of thousands of dollars in legal fees to go to trial even though they think their cases are relatively strong. Therefore they agree to settle their cases just to get rid of the lawsuits.

Having financial privacy reduces the target that is painted on your chest for frivolous lawsuits since it greatly minimizes the financial incentive and maximizes the uncertainty for plaintiff attorneys to file this kind of lawsuits. There is nothing an attorney hates more than to spend his time taking a case to a court trial and be unable to collect his fees after winning. Therefore, attorneys don’t want to waste their time suing people who do not appear to own anything.

A sound asset protection plan, however, must go beyond privacy. Even though privacy can prevent most frivolous lawsuits, you still want a solid shield to protect your assets if someone decides to sue you anyway despite your apparent lack of assets.

An important tool to shield your assets from judgment collection if someone decides to sue you anyway is a charging order protecting entity. There are two entities that have such charging order protecting capabilities. They’re the limited partnerships (LPs) and the limited liability companies (LLCs).

WHAT IS A CHARGING ORDER?

Before we get into what a charging order is, let’s look at a brief history of this legal concept. More than 100 years ago, a common form of business structure was the partnership. Many people got together and formed partnerships to conduct businesses. Since partnerships did not have any legal status separate from their individual owner-partners back then, they couldn’t own assets in their own right. Business assets in the partnerships were viewed as owned by the partners collectively. This situation made lives very complicated for the partnership when one of the partners ran into financial troubles.

Let’s look at an example to illustrate this point. Three people formed a partnership to start a merchant marine business. They each contributed capital into the partnership and bought ships and warehouses. The business was doing well after a few years. Unfortunately, one of the partners, due to the failure of another business of his, incurred massive debts. His creditors, unable to collect from him personally, came and seized one-third of the assets in the merchant marine business. The seizure of the partnership assets left the business in financial ruin when it missed many freight delivery dates and goods were spoiled without proper warehousing. The two other partners, innocent by all accounts, were injured as the direct result of this act of asset seizure by the creditors.

To avoid such chaotic collection practices as illustrated by the example above, businesses lobbied the state legislatures for reform and the concept of the charging order was born. At the turn of the 20th century, through the introduction of the Uniform Partnership Act and the Uniform Limited Partnership Act (and their subsequent revisions), a creditor who tried to collect from his debtor’s interest in a partnership was limited to a charging order. After these legislations were enacted, creditors of a debtor-partner could no longer seize assets from inside the partnership. They could only request a charging order from the court to charge the ownership interest of the debtor partner in the partnership.

In a nutshell, a charging order is a court order commanding the partnership to redirect any distributions intended for the debtor-partner to the creditor to satisfy the debt of the partner if and when distributions are made. In other words, if Partner A’s (in a three-member equal partnership) interest in his partnership is under a charging order, and if the partnership distributes a total of $600,000 to its three partners and Partner A is to receive $200,000, that $200,000 distribution must be paid to the creditor of Partner A instead. The keywords here are “if and when.” If the partnership does not make a distribution, the creditor gets nothing.

Let’s review the charging order again:

Assets inside the partnership are protected against seizure from the creditors of a partner

Creditors of a partner can only request a charging order to charge the interest of the indebted partner. Distributions from the partnership intended for the debtor-partner must be redirected to the creditors under a charging order if and when distributions are made

If no distributions are made from the partnership, the creditors get nothing.

These charging order protective features sound like a solid asset protection shield, don’t they? Yes, they are but there is one more. It’s called the K-1 surprise.

K-1 SURPRISE

Since the charging order creditor has the rights of an assignee to the financial interest of the debtor-partner and since a partnership is a pass-through entity for income tax purposes, the creditor is, therefore, obligated to pay taxes on the debtor-partner’s share of the income in the partnership. In other words, if the partnership generates $600,000 in profit in a calendar year, each partner will get a K-1 (partner’s share of profit and loss statement) at the end of the year for $200,000 from the accountant of the partnership. Each partner is responsible for paying income tax on his share of the profit ($200,000) whether the partnership distributes any of that profit to him or not. Now if one of the partners is under a charging order, the charging order creditor will get the K-1 instead and be responsible for paying income tax on that $200,000 profit whether he has received any distributions from the partnership. Now if the partnership doesn’t make any distribution and the charging order creditor must pay income tax on $200,000 of partnership profit at the end of the year, how long do you think it will take him to run over to ask for a settlement at pennies on the dollar? Now you see how powerful this charging order protection is?

About thirty years ago, the limited liability company (LLC) structure was born in the U.S. The LLC is a hybrid between a limited partnership and corporation. The Uniform Limited Liability Company Act inherited all the charging order protection features of the limited partnership. Therefore, both the LP and the LLC structures offer the charging order protection features discussed above.

Now the Uniform Limited Partnership Act and the Uniform Limited Liability Company Act are anything but uniform. All the states have modified these acts to suit their needs. Most states now allow the foreclosure of a charging order if the charging order creditor is not getting distribution from the partnership. The foreclosure of a charging order will essentially allow the charging order creditor to take over many of the debtor-partner’s rights in the partnership and to seize the assets in the partnership. Only a few states specifically in their statutes restrict the remedy of a creditor solely to the charging order without the possibility of foreclosure. Therefore, forming the LLC/LP in the right jurisdiction AND to have in place a properly drafted operating agreement for the LLC/LP with such a restriction are critical in proper asset protection planning.

DISCLAIMER: All information contained in this website is for education purpose only. Asset Protection Consulting Group, Inc., their agents and affiliates cannot and will not render any legal or tax advice of any kind, unless said agent is duly licensed by the applicable state and/or federal authority to give said advice.